MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 19

SOURCES OF INTERMEDIATE AND LONG-TERM

FINANCING: DEBT AND EQUITY

I. Questions

1. The bond agreement specifies such basic items as the par value, the
coupon rate, and the maturity date.

2. The priority of claims can be determined as follows:

senior secured debt,

junior secured debt,
senior debenture,
subordinated debenture,
preference shares,
ordinary shares.

3. Bond conversion.

4. The advantages of debt are:

a. Interest payments are tax deductible.

b. The financial obligation is clearly specified and of a fixed nature.
c. In an inflationary economy, debt may be paid back with cheaper
pesos.
d. The use of debt, up to a prudent point, may lower the cost of capital
to the firm.

The disadvantages are:

a. Interest and principal payment obligations are set by contract and

must be paid regardless of economic circumstances.
b. Bond indenture agreements may place burdensome restrictions on
the firm.
c. Debt, utilized beyond a given point, may serve as a depressant on
outstanding ordinary shares.

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Chapter 19 Sources of Intermediate and Long-term Financing: Debt and Equity

II. Multiple Choice

1. D 16. D 31. A
2. D 17. C 32. C
3. D 18. B 33. D
4. B 19. A 34. A
5. A 20. C 35. C
6. C 21. A 36. C
6. C 22. C 37. A
7. E 23. B 38. A
8. D 24. B 39. D
9. B 25. B 40. C
11. C 26. A 41. C
12. D 27. A 42. A
13. D 28. C 43. D
14. A 29. C 44. B
15. D 30. B 45. C

Supporting computations:

16.
Px =

where Px = value
(Po of
x aN)share
+ 5ex-rights
Po = marketNvalue
+ 1 of share rights-on
N = number of rights required to purchase one share
S = subscription price per share

Hence, Px = = = P72

(P75 x 4) + P60 360

18. The following schedule applies for the term loan: 5
5

Beginning Interest Principal Ending

Year Balance x (1 – Tc ) Payment Balance
1 P5000 P195 P1000 P4000

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 Sources of Intermediate and Long-term Financing: Debt and Equity Chapter 19

2 4000 156 1000 3000

3 3000 117 1000 2000
4 2000 78 1000 1000
5 1000 39 1000 -0-

The present value of interest after taxes at 12% is calculated to be

P453.49.

19. After the tax benefit, the annual cost of leasing is P1,400 (1 – .35) =
P910. The present value annuity factor for four years at 12% is 3.0373.
The present value cost of the lease is the cost of the first payment plus
the present value of the four future payments, or P910 + P910 (3.0373)
= P3,673.94.

20. The present value annuity factor for five years at 12% is 3.6048.
Therefore, the present value of principal payments is P1,000 (3.6048) =
P3,604.80. The present value cost of the purchase option is the present
value of principal payments or P3,604.80 plus P453.49 which equals
P4,058.29.

III. Problems

PROBLEM 1 (CAM FURNITURE COMPANY)

a. Proposal 1: 10 year 12 percent bonds

CAM FURNITURE COMPANY

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Chapter 19 Sources of Intermediate and Long-term Financing: Debt and Equity

Income Statement
P30,000
For the Year Ended December 31, 2005
3*
Estimated sales levels
Sales........................................ P400,000 P600,000 P800,000
Operating costs........................ 360,000 540,000 720,000
Operating income.................... 40,000 60,000 80,000
Interest charges........................ 14,000 14,000 14,000
Net income before taxes.......... 26,000 46,000 66,000
Income taxes............................ 13,000 23,000 33,000
Net income.............................. P 13,000 P 23,000 P 33,000

Outstanding shares = = 10,000

* EPS (P36 market value – price earnings ratio of 12)

Earnings per share P1.30 P2.30 P3.30

Price-earnings ratio 10 times 10 times 10 times
Estimated market value P100,000 P13 P23 P33
33 - 1/3
Proposal 2: Ordinary share issue to yield P33-1/3
CAM FURNITURE COMPANY
Income Statement
For the Year Ended December 31, 2005
Estimated sales levels
Sales........................................ P400,000 P600,000 P800,000
Operating costs........................ 360,000 540,000 720,000
Operating income.................... 40,000 60,000 80,000
Interest charges........................ 2,000 2,000 2,000
Net income before taxes.......... 38,000 58,000 78,000
Income taxes............................ 19,000 29,000 39,000
Net income.............................. P 19,000 P 29,000 P 39,000

Outstanding shares = + 10,000 = 13,000 shares

Earnings per share P1.46 P2.23 P3.00

Price-earnings ratio 12 times 12 times 12 times
Estimated market value P17.52 P26.76 P36.00

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Sources of Intermediate and Long-term Financing: Debt and Equity Chapter 19

b. Within the constraints of this problem, two possible objectives emerge:

profit maximization as measured by earnings per share and wealth
maximization as measured by the price of the ordinary shares. If profit
maximization is used, the firm should choose to finance the new product
by selling bonds, since earnings per share is higher for each of the three
levels of sales. On the other hand, wealth maximization would require
the sale of new ordinary shares because share price is higher at each sales
level.

Wealth maximization is the preferred criterion for financial decision

making. Unlike profit maximization, it represents a measure of the total
benefits stream to be enjoyed by the shareholders, adjusted for both the
timing of benefits and the risk associated with the receipt thereof. A
criterion that ignores these two important determinants of value cannot
be expected to provide a proper guide to decision making.

Because wealth maximization is the preferred objective, the sale of

ordinary shares is the recommended financing technique.

c. Proposal 2 would still be the choice, because the market value remains
above that of Proposal 1. The difference is getting smaller, however,
which means that Proposal 1 would become attractive if sales reached a
higher level (approximately P1.6 million).

d. The investment banker would suggest that lower price-earnings ratio

with debt financing is a reflection of the greater returns demanded by
shareholders in compensation for the variability in earnings and higher
risk of bankruptcy created by the fixed commitment to pay debt interest
and principal.

PROBLEM 2 (FAYE INDUSTRIES, INC.)

Faye Industries Inc.

Pro Forma Consolidated Income Statement
Including Earnings per Common Share
and
Return on Average Common Shareholders’ Equity
For the Year Ending November 30, 2006
(P000 omitted except per share amounts)

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Chapter 19 Sources of Intermediate and Long-term Financing: Debt and Equity

(1) Issuing (2) Selling (3) Selling

Long-term Preference Ordinary
Bonds Shares Shares
Earnings before interest and taxes P12,978 P12,978 P12,978
Interest on
Current debt (P13,395 x 9.5%) 1,273 1,273 1,273
Alternative 1 (P15,300 x 10%) 1,530
Total interest 2,083 1,273 1,273
Income before income tax 10,175 11,705 11,705
Income taxes (40%) 4,070 4,682 4,682
Net income 6,105 7,023 7,023
Preference share dividends (P15,300,000  P120) x 1,658
13%
Earnings available to common shareholders 6,105 5,365 7,023
Add: Common shareholders’ equity December 1, 1999 55,028 55,028 55,028
Equity financing 15,300
Common shareholders’ equity November 30, 2000 P61,133 P60,393 P77,351

Average common shares outstanding (in thousands)

December 1, 1999 balance 26,330 26,330 26,330
Additional issued December 1 7,650
Total (and average) shares outstanding 26,330 26,330 33,980

Pro forma earnings per share

(P6,105  P0)  26,330 = P0.2319
(P7,023  P1,658)  26,330 = P0.2038
(P7.023  P0)  33,980 = P0.2067

Estimated return on average common shareholders’

equity
P6,105  [(P55,028  P61,133)  2] = 10.51%
P5,365  [(P55,028  P60,393)  2] = 9.30%
P7,023  [(P70,328  P77,351)  2] = 9.511%

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